Rates from Bankrate.com

Mortgage

Credit Cards

Auto

You Can Still Get an Interest-Only ARM

Written by: Jeff Brown10/10/13 - 10:00 AM EDT

NEW YORK ( TheStreet) -- Everyone knows the exotic mortgage types -- or toxic ones, in many cases -- are a thing of the past, left to the dustbin of the pre-crisis days. Well, not exactly. Look hard enough and you'll see that not every borrower has to settle for a standard 15- or 30-year fixed-rate loan.

How about an interest-only ARM? Yes, they exist, and can be useful for borrowers who know what they are doing and can stomach some risk, or plan to pay the loan off in just a few years instead of keeping it for the full 30 years.

The worst offenders of the bad old days are indeed gone -- things such as negative-amortization loans where the debt grew over time instead of getting smaller. But there are plenty of adjustable-rate mortgages, where the interest rate resets every year after an initial period.

Typically, the starting ARM rate is lower than you'd get on a fixed-rate loan, where the rate will stay the same for the entire 15 or 30 years. But with a 30-year ARM, you face the risk of a higher rate after the initial period, typically one, three, five, seven or 10 years.

With an interest-only ARM, you pay interest but not principal for an initial period of, say, five years, keeping the monthly payment very low. The downside is that once the principal payments begin, they are quite large, since the debt must be paid off in the shorter period that remains -- 20 to 25 years instead of 30, for instance.

And because the debt doesn't shrink during those interest-only years, the interest charges will be higher in the later years, since interest will be applied to a larger loan balance. Over the long run, an interest-only ARM could well be more expensive than an interest-and-principal ARM or a fixed-rate loan.

So the best IO ARM candidate is a borrower who expects to pay the loan off early, ideally before the interest-only period ends. Suppose, for example, that you want to buy a new home while prices are still relatively low, but don't want to sell the old one until prices rise. An interest-only ARM could give you that breathing room, minimizing the payments on the new loan for the few years you will support two properties.

Quicken Loans , for example, offers a five-year interest-only loan through an agreement with Charles Schwab , the brokerage, that charges 3.5% for 60 months, then adjusts annually for the remainder of the 30 years. Though the interest rate can go up by as much as 5 percentage points after five years, principal payments do not begin for 10 years.